Chapter 12 Cash Flow Estimation and Risk Analysis 387SEL
F^ TEST What is done in the post-audit?
Identify several bene" ts of the post-audit.
What are some factors that complicate the post-audit process?This chapter focused on estimating the cash! ows that are used in a capital budget-
ing analysis, appraising the riskiness of those! ows, " nding NPVs when risk is pres-
ent, and determining the values of real options, which can raise expected returns
and lower risks. Here is a summary of our primary conclusions:
• (^) Some cash! ows are relevant (hence, should be included in a capital budgeting
analysis), while others should not be included. The key question is this: Is the
cash! ow incremental in the sense that it will occur if and only if the project is
accepted?
• (^) Sunk costs are not incremental costs—they are not a# ected by accepting or
rejecting the project. Cannibalization and other externalities, on the other hand,
are incremental—they will occur if and only if the project is accepted.
• (^) The cash! ows used to analyze a project are di# erent from a project’s net income.
One important factor is that depreciation is deducted when accountants calcu-
late net income; but because it is a noncash charge, it must be added back to
" nd cash! ows.
• (^) Many projects require additional net working capital. Net working capital is a
nega tive! ow when the project is started but a positive! ow at the end of the
project’s life, when the capital is recovered.
• (^) We considered two types of projects—expansion and replacement. For a replace-
ment project, we " nd the di# erence in the cash! ows when the " rm continues to
use the old asset versus the new asset. If the NPV of the di# erential! ows is posi-
tive, the replacement should be made.
• (^) The forecasted cash! ows (and hence NPV and other outputs) are only estimates—
they may turn out to be incorrect, and this means risk.
• (^) There are three types of risk: stand-alone, within-firm, and market (or beta) risk.
In theory, market risk is most relevant; but since it cannot be measured for
most projects, stand-alone risk is the one on which we generally focus. How-
ever, firms subjectively consider within-firm and market risk, which they defi-
nitely should not ignore. Note, though, that since the three types of risk are
generally positively correlated, stand-alone risk is often a good proxy for the
other risks.
• (^) Stand-alone risk can be analyzed using sensitivity analysis, scenario analysis, and/
or Monte Carlo simulation.
• (^) Once a decision has been made about a project’s relative risk, we determine a risk-
adjusted WACC for evaluating it.
T Y I N G I T A L L T O G E T H E R